Code Section 162(m) limits the amount of annual compensation that may be deducted by a public company for each of its top four executives to $1 million. Certain types of compensation are not subject to the limit, including compensation that is performancebased within the meaning of IRS regulations. The following summarizes the requirements for the performance-based exception.

Performance-Based Exception – General Requirements

Generally, compensation will be deemed to be “performance-based” if it meets the following requirements:

  • The compensation must be paid solely on account of attainment of one or more pre-established performance goals, pursuant to an objective compensation formula;
  • The performance goal(s) must be established by a compensation committee comprised solely of two or more outside directors;
  • The compensation must be paid pursuant to a shareholder-approved plan; and
  • The compensation committee must certify, in writing, prior to payment of the compensation that the performance goal(s) and any other material terms were satisfied.

Each of these requirements is described in more detail below.

Pre-established Performance Goals

A performance goal is considered pre-established only if it is established in writing by the compensation committee no later than 90 days after the beginning of the period of service to which it relates.

  • The outcome must be substantially uncertain at the time the performance goal is established.
  • The performance goal must be objective, which means that a third party, having knowledge of the relevant facts, could determine if the goal is met.
  • The performance goal must state, pursuant to an objective formula or standard, the method for computing the amount of compensation.
  • The terms of the objective formula must preclude discretion to increase the amount of compensation (negative discretion is permitted). If the formula is stated as a percentage of salary or base pay, either the amount of salary or base pay has to be fixed at the time the goal is established, or the plan has to include a maximum dollar amount that can be paid.
  • Payment must be contingent on attainment of the performance goal. Payment will not be considered contingent if facts and circumstances indicate the employee would receive all or part of the compensation regardless of whether the performance goal is attained.
  • The plan may include a feature that pays a certain amount of compensation in the event of death, disability or change of control, regardless of whether the performance goals are attained. However, any payments made due to these circumstances will not be performance-based. The IRS issued a revenue ruling in early 2008 advising employers that this exception will no longer extend to amounts paid without regard to attainment of the performance goals on retirement or involuntary termination of employment. The revenue ruling is generally effective for performance periods beginning after Jan. 1, 2009.

Compensation Committee

The performance goals must be established by a committee consisting of two or more outside directors. Generally, a director is considered an outside director if all of the following requirements are satisfied:

  • The director is not a current employee of the company.
  • The director is not a former employee of the company who is receiving compensation for prior services (other than under a tax-qualified retirement plan).
  • The director has not been an officer of the company.
  • The director does not receive remuneration from the company, either directly or indirectly, in any capacity other than as a director. The regulations contain complex rules for determining when this requirement is met.

Shareholder Approved Plan

  • The material terms of the plan must be disclosed to and approved by shareholders before the compensation is paid. This requirement is not satisfied if the compensation would be paid regardless of shareholder approval.
  • Material terms that must be disclosed include the employees eligible to receive compensation, a description of the business criteria on which the performance goal is based, and either the maximum amount of compensation that could be paid to any employee or the formula used to calculate the amount of compensation. It is not necessary to disclose the specific targets that must be satisfied under the performance goal.
  • The disclosure must be specific enough that a shareholder can determine the maximum amount of compensation that could be paid to any employee during a specified period. If the formula is a percentage of salary or base pay, the maximum dollar amount that could be paid must be disclosed. Otherwise, the disclosure must include the formula under which the compensation would be calculated.
  • If the compensation committee has authority to change the targets under a performance goal after shareholder approval of the goal, the material terms of the performance goal must be disclosed to and reapproved by shareholders every five years.

Compensation Committee Certification

  • Prior to payment, the compensation committee must certify in writing that the performance goals and any other material terms were in fact satisfied. For this purpose, approved minutes of the compensation committee are treated as written certification.

Five Common Compliance Issues

The regulations are complex, so there are many possible areas where employers can inadvertently fail to comply with the requirements of the performance-based exception. However, in our experience, the following are the most often-seen compliance issues.

  1. Failure to obtain new shareholder approval every five years. It sounds like a simple requirement, but it is frequently overlooked by companies. In some cases, an employer may add shares during the five-year period, but only have the shareholders approve the additional shares, rather than reapprove the material terms of the performance goals.
  2. Use of a performance goal that is not included in the shareholder-approved plan. Although this has become less of an issue in recent years as employers develop a more comprehensive “laundry list” of possible performance goals, we have seen some employers use performance goals that are not in the shareholder-approved plan.]
  3. Failure to establish the performance goals in writing during the first 90 days of the performance period or when outcome is substantially uncertain. Again, this sounds like a simple requirement; however, it is not enough to have the compensation committee establish the performance measures in principle. The actual targets and the compensation formula must be established, in writing, during this period and at a time when the outcome is substantially uncertain.
  4. Payment of compensation when performance goals are not attained. Every year we see some employers who want to pay the targeted bonus even when the performance goals are not attained. Clearly such a payment would not qualify for the performance-based exception. However, it could also jeopardize the performance-based exception for prior or future bonuses. Remember, one of the requirements is that the compensation must be paid solely on account of attainment of the pre-established performance targets, and will not be so considered if facts and circumstances indicate it would be paid regardless of performance.
  5. Adjusting bonus amount for subsequent events (i.e., sale or acquisition of business unit). It is possible to adjust performance measures for certain objective subsequent events. However, this feature must be included in the performance goal and formula when initially established and not added at the end of the performance period.